Question

Assume you are the CEO of a publically traded company. Your chief financial officer (CFO) informs you that your company will not be able to meet earnings per share targets for the current year. In that event your stock price will likely decline. The CFO proposes reducing the quarterly provision for uncollectible amounts (bad debt expense) to increase your EPS to the level analysts expect. This will result in an allowance that is less than it should be. The CFO explains that outsiders cannot easily detect a reduction in this allowance and that the allowance can be increased next year. The benefit is that your shareholders will not experience a decline in stock price.

1. Identify the parties likely to be affected by this proposed action.

2. How will reducing the provision for uncollectible accounts affect the income statement and the balance sheet?

3. How will reducing the provision for uncollectible accounts in the current period affect the income statement and the balance sheet in a future period?

4. What argument might the CFO use to convince the company's internal auditors that this action is justified?

5. How might an analyst detect this earnings management activity?

6. How might this action affect the moral compass of your company? What repercussions might this action have?

Answer 1

1. The parties likely to be affected by this decision are the investors, employees, management and auditors of the company.

2. Reducing the provision for bad debts would result in more net operating profit in the income statement as the debit to the profit and loss account shall be reduced. It shall increase the net debtors in the balance sheet.

3) If provision is reduced in the current period and the amount becomes unrecoverable , it will be a hit on the profit and loss and will reduce the benefits.Debtors will have to be written off and current assets will reduce.

4.The CFO might argue that on confirming with the parties and their judgement it is safe to assume that most of the recovery from the debtors shall be made.

5. The analyst can ask for third party confirmations to justify the basis for the reduction of provision for bad debts.

6. Initially, since a high profit shall be reported, the morale of the employee shall be boosted.However, once the amount becomes unrecoverable , there will be a sudden drop in profit and loss and this shall have adverse effects.